A partnership is a formal business arrangement between two or more parties to jointly manage a business, and share profits and liabilities. However, how duties are managed, along with how profits and liabilities are shared, can differ between partners. A significant aspect of this concerns material participation. Depending on the level of involvement in a partnership, a partner can either be considered active, or passive. This distinction can have implications in tax liability, filing, and can even affect the terms of a partnership agreement.
Understanding Participation in Partnerships
The difference between an active or passive partner doesn’t just affect the day-to-day running of a partnership. It also has implications for tax liability, according to the IRS. While both types of partner invest in a business, the differentiation revolves around their level of involvement in actually running the business. An active partner, as the name suggests, is actively involved in the daily operations of a partnership. As such, they’re sometimes known as a managing or ostensible partner. There are a number of benefits to being an active partner. These include:
- Retirement Plan Contributions: As an active partner, you can contribute to retirement plans based on your partnership earnings. These contributions can provide a number of tax advantages, including reducing your taxable income.
- Self-Employment Income: Active participation means your earnings are considered self-employment income, which gives you access to deductions for health insurance premiums and half of the self-employment tax paid, reducing your tax burden.
A passive partner, according to the IRS, does not materially participate in trade or business activities. In other words, they share in the business’ profits and losses, without being involved in the daily activities. This is why such partners are also known as dormant partners.
Criteria used to differentiate participation
In order to establish whether you are an active or passive partner, the IRS makes use of material participation tests. This assesses whether or not you participate in an income-producing activity. If you pass one or more of the seven tests listed below, you’re considered an active partner. If not, you’re classified as a passive partner.
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Material participation tests
In a nutshell, the tests are based on the number of hours you’ve worked, and the type of activity completed.
- 500 Hour Test. To pass this test, you must participate in a business activity for more than 500 hours in a tax year. This includes attending meetings, handling admin, or making management decisions.
- Regular, Continuous, and Substantial Activity Test. This evaluates whether your involvement in business activities is regular, continuous, and substantial compared to other employees.
- Maximum Participation Test. Here, you need to participate in the business for more than 100 hours in a tax period, with greater involvement than other employees.
- The Significant Participation Activity (SPA) Test. This assesses your involvement in Significant Participation Activities for more than 500 hours in a tax year. This test generally only applies to partners who have failed every previous test to prove material participation.
- Historical Participation Test. For this test, you must have participated in a specific business activity for at least five years over the last ten tax years.
- Personal Service Activity Test. This applies to partners engaged in personal service activities (like law, medicine, accounting, or consulting). It stipulates that you must have participated in a service activity for three of the past five tax years.
- Facts and Circumstances Test. This considers your expertise, time devoted to a business activity, as well as your role in decision-making, when the other six tests do not apply.
There are a few exceptions to the above tests, so if you are unsure whether you will be classified as an active or passive partner, it’s best to consult with a tax expert.
Active and passive participation in action
Consider, for example, that you enter into a partnership to run a rental property business. You and your partners all put down capital to invest in the business, but only one of you (partner A) has previous experience in running this kind of company. As such, partner A might naturally end up being the one to handle the day-to-day running of your company, even though the others still stay informed about what’s happening, and have invested in the business. Partner A is the active partner, while everyone else is a passive partner. This distinction should be laid out in your partnership agreement, because whether income is considered active or passive has different tax implications.
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Tax Implications of Participation Status
The IRS taxes revenue received by active and partners differently. This is treated as active and passive income, respectively. In a partnership, active income is taxed as pass-through income, and is recorded on your personal income tax return. This helps to avoid double taxation on the same revenue. Both types of income are reported on Form 1065, with the activities of each outlined on Schedule K-1.
Passive income taxation
In terms of participation status, the IRS defines passive income as that from ‘trade or business activities in which you don’t materially participate during the year’. When reporting passive income, it’s possible to group multiple activities for tax purposes, as long as they fall under ‘an appropriate economic unit’. This refers to common control and ownership, geographical location, and similarities in the type of business activity. This way, you only have to prove material participation for one of your grouped activities. As for how much tax you’ll pay on passive income, this is determined according to your tax bracket. Unless, that is, your modified adjusted gross income is above a certain threshold, in which case you’ll be subject to the Net Investment Income Tax (NIIT) rate of 3.8%.
Passive Activity Loss (PAL) rules
It’s possible to offset passive income with any passive losses. However, if your passive losses exceed your income, you can’t deduct the entire loss from your taxable income. Instead, it’s rolled over to the next tax year. Note that PAL rules do not apply to active income. The complete rules are outlined under Section 469 of the Internal Revenue Code (IRC).
Active income taxation
Several factors can affect the taxation of active income in a partnership. These include:
- Self-Employment Taxes: Partners who receive active income are usually subject to self-employment taxes.
- Deductions and Credits: You may be able to deduct certain expenses related to your partnership income. You might also qualify for tax credits based on your partnership’s operations and your share of its income.
- State Taxes: In addition to federal taxes, you may also be subject to state and local taxes on your share of partnership income, depending on where your partnership operates and where you live.
If you have any questions about how your participation status in a partnership affects your taxes, reach out to one of our CPAs.
Strategies for Managing Your Tax Liabilities
Regardless of your participation status in a partnership, there are a few ways to manage your tax liability. If you’re an active partner, consider the following:
- The IRS offers the chance to deduct up to 20% of qualified business income. This is essentially up to 20% of your business’s net profit. However, it excludes capital gains and losses, dividends, interest income, wages, or money earned outside the country.
- You can maximize charitable donations to exceed the standard deduction in certain tax years.
- By leveraging depreciation benefits on qualifying assets, you may be able to claim immediate deductions.
However, if you’re a passive partner, consider achieving real estate professional status to convert passive losses into active ones, in order to deduct these against other income.
For a tailored plan to help you manage your taxes depending on your participation status, schedule a Discovery Call with one of our expert CPAs.
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